Sustainable investing is a global phenomenon that seeks to provide a framework for including environmental, social and governance (ESG) factors into everyday investment decisions. What began as ‘ethical investing’ on religious grounds has evolved into a multi-trillion dollar industry. The whole global economy is now transitioning towards a more sustainable – and lower-carbon – business and investment model, led by the need to tackle climate change.

The United Nations defined it this way when it launched its Principles for Responsible Investment (UNPRI) in 2005:

“Responsible investment is a strategy and practice to incorporate environmental, social and governance (ESG) factors in investment decisions and active ownership.” ¹

Environmental factors typically target pollution, waste disposal and lately, the emissions of countries and companies as the world tries to reduce global warming. Social factors focus on human rights, labor issues and diversity. Governance factors range from ensuring companies are well-run – taking decisions that benefit all shareholders and stakeholders and not just directors – as well as the avoidance of issues such as bribery and corruption.

Many investors now take responsible investing one stage further and adopt specific sustainability characteristics such as better carbon footprints or higher ESG scores in the belief this will enhance returns. We call this sustainable investing, and its use as a means of trying to improve risk-adjusted returns is discussed in more detail in Chapter 6.

Impact investing goes further still in requiring a direct consequence of the investment on the ground without necessarily also requiring a superior financial return, depending on the objective. The key differences between these styles is shown in the graphic below:

Figure 1 – The spectrum of capital

Source: Global Sustainable Investment Alliance 2020

Sustainable investing adopts progressive ESG practices that may enhance value. In addition, the concept of double materiality is used. Investors must not only look at how sustainable development is affecting business models of companies and thus their financial value; investors must also look at what effect the company (or country) has on the world as well.

Sustainable investing has therefore moved on significantly in recent years to include a bigger emphasis on active ownership (voting and engagement), and a rise in the use of impact investing, where the investment seeks to make a real-world impact such as by focusing on positive contributions towards the UN’s Sustainable Development Goals (SDGs).

In all, sustainable investing has brought the concept of creating wealth and well-being; it is no longer acceptable to just look for profits.

Table 1: The amount of assets under management that are managed sustainably

Source: Global Sustainable Investment Alliance 2020

These developments have led to sustainable investing (including ESG integration) massively growing over the past two decades. SI accounted for 35.9% of total assets under management in 2020, up from 33.4% in 2018, according to the Global Sustainable Investment Alliance.² SI use is biggest in Canada, where 61.8% of assets were managed sustainably. In Europe, 41.6% of assets were managed under SI principles, amounting to investments worth more than EUR 10.7 trillion. That’s equivalent to almost half the annual GDP of the United States.

Figure 2: The rise in global sustainable investments from 2016 to 2020 in USD trillion

Source: Global Sustainable Investment Alliance 2020

Figure 3: Each region’s share of total sustainable assets globally

Source: Global Sustainable Investment Alliance 2020

Indeed, it has come a long way since its origins in the 18th century, when the Quakers refused to invest in anything involved with the slave trade, creating the first exclusions. In more recent times, the concept of improving human equality to create a better world began with the political climate and first equal rights legislation in the 1960s. One of the first major uses of exclusions was seen in the 1970s when companies refused to invest in South Africa due to its apartheid regime.

Sustainability reached the global stage in 1987 when the United Nations World Commission on Environment and Development – known as the Brundtland Commission – released a report entitled ‘Our Common Future’. It is most notable for coining the term ‘sustainable development’, which it defined as “development that meets the needs of the present without compromising the ability of future generations to meet their own needs.”³

Tying this into general business activities later led to a concept of the ‘three Ps’ – People, Planet, Profit – gaining traction in the 1990s. This argued that a business-minded focus on each of these three words (and not just profit) were equally important for any commercial enterprise to be sustainable.⁴

This was adapted to become a focus on ESG, a different three letters which forms the bedrock of most sustainable investing processes. The focus on the E has risen in recent years as combatting climate change has become more urgent, with a focus on net-zero carbon commitments and meeting the Paris Agreement goals. Covid has additionally raised the importance of the S as so many people were badly impacted by the pandemic. And the G remains vital as companies are challenged as to how they are handling decarbonization at board level downwards.

Another significant development has been the advent of the SDGs. These aim to route investment cash into any one of the 17 goals ranging from eradicating poverty and removing inequalities to protecting biodiversity and advancing sustainable production. This has raised the importance of making a real-world impact – making a difference to lives on the ground while also making a financial return. (See the Essentials of SDG Investing for our online module about this).

With the focus now on integrating ESG, using active ownership and making a real-world impact through the investee companies, sustainable investing is no longer limited to exclusions. It’s become part of the routine mix of financial analysis that is used globally, has become mainstream, and is no longer only a ‘rebel with a cause’.

You should now understand how SI has evolved from a protest movement to an investment style that is focused on ESG factors, with a bigger emphasis on impact investing.

Footnotes

¹ UNPRI
² Global Sustainable Investment Alliance 2020 Review
³ ‘Our Common Future’, the Brundtland Commission
⁴ John Elkington, ‘Enter the triple bottom line’, 2004

Sustainable investing is not one catch-all concept – there is a broad range of different styles and preferences in doing it, with no ‘right or wrong’ way of going about it. However, there is a strong consensus about what it is intended to do, using the overarching principle of double materiality that affects all companies and investments.

The phrase was coined in 2019 by the European Commission which said one should look at the effect that a company has on the environment and wider society as well as the factors that affect its business.⁵ One such focus has been on emissions; how much carbon does a company produce while making or supplying its product or service? An energy company may well be an attractive investment, but its profits will come at a cost to the environment, and this needs to be figured into the investment decision-making process.

Such analysis has led to many investors taking a much stricter approach to sustainability – but approaches still differ. Their motivation may be not wanting to invest in contentious things such as high-carbon companies. They may want to use SI as a means of improving their risk/return profile. Or they may like the idea of contributing towards positive change. These three typical motivations can be captured through exclusions, ESG integration and impact investing, respectively.

Figure 4: Approaching sustainable investing from different lenses

Source: Robeco

Exclusions: The classic way of engaging in SI, and still the most commonly used, is by refusing to invest in a company that has controversial business practices. This ranges from business activities deemed to be harmful to health or the environment, such as tobacco or Arctic oil drilling, to outright criminal behavior such as corruption or forced labor. Some companies must be compulsorily excluded under national laws, such as legislation that prohibits investment in the manufacturers of cluster bombs. Exclusions are the principal form of negative screening.

Figure 5: Typical exclusions

Source: Robeco

ESG integration: This is the systematic use of financially material ESG criteria to better understand the impact of sustainable development on companies’ business models. The sole purpose of ESG integration is to make better-informed investment decisions and thereby help to generate alpha. It is important though to only consider financially material criteria: factors that directly affect the bottom line. If not, it cannot be proven that it is directly enhancing (or subtracting from) performance, and so it should not be considered.

Impact investing: This involves making investments with the aim of creating a measurable beneficial impact on the environment or society, as well as earning a positive financial return. Popular themes for this are the Sustainable Development Goals. Impact investing has three key components. First, there must be intentionality: an investor is making a deliberate, targeted effort to exert a positive impact. Second, it should generate a positive return on investment; this is not charity. And third, the financial, social and environmental benefits of impact investment should be measurable and transparent. It is not the same as ESG integration, which does not necessarily seek to make an impact on the ground.

So, which one is best for whom?

ESG integration is a good option for investors who want to ‘mainstream’ ESG and not use it in isolation, but as part of a wider, more holistic approach. Such investors believe that using ESG information leads to better-informed investment decisions and a better risk/return profile. It is done purely for financial reasons, so it does not necessarily lead to a more sustainable portfolio. However, if done well, companies that are being impacted by severe ESG risks will be less attractive to invest in and vice versa, while companies with good ESG management will become more attractive.

Impact investing is best done by investors who want to make a positive impact on society through the companies in which they invest, while believing that they can generate sufficient investment returns while doing so. Specifically targeting investing in renewable energy, for example, helps the fight against global warming while also making a financial return from the sale of the electricity generated. Investors interested in furthering the SDGs also typically turn to impact strategies.

Another means of generating a positive impact is through active ownership. This is a useful instrument for investors in listed equity and fixed income, where the additionality argument (providing new capital) is less strong. Voting and engagement on sustainability issues can be the most direct approach to bring about change and impact when investing in listed securities.

Avoiding a negative impact by using exclusions is most suitable for investors with a clear vision on which products or behaviors are incompatible with what they or their stakeholders deem to be important. Some professional investors have ‘red lines’; for example, health insurers tend to exclude companies making products that are detrimental to general health, such as cigarettes.

Most investors will choose a mixture of these three styles. Some simply do not want to invest in controversial products or services and will use exclusions to avoid them. They would rather invest in companies or countries that have good track records in the ESG issues that matter most to them.

Others want to profit from sustainable development by investing in companies that create solutions for certain sustainability issues such as climate change, inequality, or improving health. Or they want to create a positive impact with their investments. These goals are tied to impact investing.

Those using ESG integration, as it is commonly defined, will be doing it for financial reasons in order to make better-informed investment decisions and pursue superior risk-adjusted financial returns. As the goals of the end-investors can be different, there is room for multiple tools and strategies to be implemented alongside each other in the investment process.

You should now be able to explain the different approaches to SI and establish your client’s motivations for choosing a particular one.

Footnote

⁵ https://ec.europa.eu/commission/presscorner/detail/en/QANDA_21_1806

As we saw in , ESG integration is one of the three main ways of adopting SI. The United Nations Principles for Responsible Investment defines this process as:

“The explicit and systematic inclusion of environmental, social and governance issues in investment analysis and investment decisions. Put another way, ESG integration is the analysis of all material factors in investment analysis and investment decisions, including environmental, social, and governance factors.”⁶

What is key here is ‘financial materiality’ – the factors being considered are not just ‘nice to have’, but have a direct impact on the company’s bottom line. For example, an investor will not look at factors such as pollution or excessive waste from the perspective of harming the environment. But such behavior may have a financial impact on the company, from attracting fines to raising costs and regulatory risks due to poor resource conservation.

ESG integration is usually done in three steps. The first is to identify and focus on the most material issues affecting the company. Then the investor can analyze the likely impact of these material factors on the company’s business model. Finally, this information can be incorporated into the valuation analysis to form a fundamental view.

Figure 6: Three-step approach to ESG integration

Source: Robeco

This ESG analysis forms part of a wider mix of traditional metrics to value the company and its prospects, and then decide whether to buy its stocks or bonds. Other factors remain important, such as the fundamentals of the business; whether its market is growing; and how profit margins can withstand future shocks, advances in technology or changing tastes. Ultimately, anything a business does needs to be sustainable, or it will face decline. Witness Kodak, which did not transform from film to digital, and filed for bankruptcy in 2012 before reemerging the following year with a different business model.

A big advantage of ESG integration is that it works across all asset classes – it has been proven to work just as well in fixed income markets as in equities, and can also be applied to commodity or real estate portfolios.

In general, ESG analysis in equities seeks to identify risks and opportunities that are not necessarily reflected in the share price, while analysis in bonds seeks to expose any downside that may not show up in its credit rating. ESG is being integrated into an existing framework that incorporates other factors, and is not used in isolation.

One way of using ESG analysis to create highly sustainable portfolios is through positive screening, where what you include is more important than what you exclude. This style specifically seeks to find securities with higher ESG scores than others, so that a better-informed decision can be made about whether to buy it.

Depending on the relative risk budget which determines how much an investor can deviate from the market, sustainability scores may also be a trigger to go overweight or underweight on the security. This means buying relatively more or less bonds than their presence in the relevant benchmark would imply. That is often preferred to including the security wholly or excluding it completely. For countries, such ESG scores would be used for investment decisions on their government bonds.

For investors who want to take this one step further and only include the most sustainable companies in their portfolio, the ‘best-in-class’ approach can be followed. This solely targets the companies with the highest ESG scores in a particular sector, and largely ignores all the others. The principal drawback is that the investor is narrowing the investment universe and may miss out on the improving, up-and-coming companies whose performance is often enhanced through engagement.

Using either positive screening or the best-in-class approach involves splitting the ESG and financial analysis into two parts. The first is to determine the size of the investable universe based on ESG scores. The second is to assess the investment potential of the companies in the universe that has been determined. Technically this is not considered ESG integration, but if the investor believes that the investable universe they have determined performs better than the market, there is clear value added from a financial perspective.

All ESG integration depends on getting relevant data about a company’s operations, for example about emissions when assessing its environmental risks and progress towards decarbonization. This has led to a growth in the data-gathering industry and methods of interpreting the research, such as the Corporate Sustainability Assessment, formerly owned by Robeco and now owned by S&P Global. Other vendors include Sustainalytics, MSCI ESG Research, Bloomberg and Refinitiv.

Data gathering, however, is not a perfect science and throws up several dilemmas. For one, all data is backward-looking and assesses a company based on its past and not its future. Emissions data, for example, reveals past levels and not how well prepared the company is to meet net-zero targets. More predictive models are now being developed to try to assess this, such as by extrapolating underlying trends to assess transition pathways.

Another issue is the data itself. Emissions are measured as either Scope 1, 2 or 3. Scope 1 are the emissions generated by the company itself, and Scope 2 the emissions of the energy used to make the products – both of which are relatively easy to find. Scope 3 encompasses the emissions of the products along the customer value chain – such as the exhaust of a car once it is sold to the driver – and are much more difficult to gather.

Then there is the problem of divergent ESG scores – ratings given to companies by differing suppliers of sustainability data. A study based on data from six prominent ESG rating agencies showed a significant divergence in the scores they allotted, due mainly to differences in the methodologies used.

Measurement practices contributed 56% of the divergence, while the scope of the analysis contributed 38% and the weight given to differing ESG characteristics contributed 6%. A rating agency’s overall view of a firm influenced the measurement of specific categories, which led the study to advise investors to pay greater attention to how the data underlying ESG ratings is generated.⁷

Summarizing, you should now see how ESG adoption can transform a portfolio, and how different types of sustainability integration have different results for clients.

Footnotes

⁶ UNPRI
⁷ https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3438533

One of the reasons why sustainable investing has moved from a niche to a mainstream style is the fact that it is directly linked to solving some of the biggest issues of our time. The most critical one is climate change, which has led to a whole genre of investing to combat global warming, from renewable energy to a wider decarbonization push.

Climate change itself is backed by a major trend of increasing regulation, new laws and wider scrutiny from society in general. the SDGs present a growing investment opportunity linked to Other trends, creating a new front for SI in impact investing. Finally, rising concern for upholding human rights is an issue that active ownership can do much to promote.

Easily the biggest trend in modern investing, combating climate change began in earnest with the signing of the Paris Agreement in 2015. This aims to limit global warming to well below 2° C above pre-industrial levels by 2100, and preferably to 1.5° C. The principal cause of global warming is widely agreed to be greenhouse gas emissions generated by human activity since the industrial revolution of the 18th century.

The latest report from the Intergovernmental Panel on Climate Change (IPCC) in 2022 said that climate change was already causing disruption in every corner of the world. Describing the situation as ‘code red for humanity’, the main conclusion was that global warming will inevitably reach 1.5°C in the 2030s – more than six decades before the 2100 target.

The IPCC said to combat this, carbon emissions must be halved this decade and adaptation scaled up immediately in order to mitigate environmental disaster and address losses and damages. (See the Essentials of Climate Investing module for more about this.)

Table 2: The consequences of global warming

Source: Carbon Brief, October 2018⁸

This has led to most governments pledging to cut emissions to become carbon neutral by 2050, principally by phasing out the use of fossil fuels in energy production and transport. Investors responded by signing the Net Zero Carbon Pledge in 2020 pledging to make all assets under management carbon neutral by 2050.

And this is not just about abolishing things: the innovation required to move away from fossil fuels is bringing massive investment opportunities. There is a vast market in electric cars, hydrogen-fueled heavier transport and the technology that lies behind it. Investments are also being made in carbon capture and reforestation, along with a move towards the circular economy using less wasteful production systems.

Much of the landscape is changing due to new laws and regulations that set limits on emissions and seek to achieve more stable financial markets. Regulation ranging from Basel III to Solvency II has put in place measures to prevent another global financial crisis, which has changed the ways in which banks and insurers operate, improving particularly their governance; the G in ESG. Lawsuits and shareholder resolutions forcing oil majors to disclose their carbon transition readiness have also had a major impact.

Other initiatives on the way include plans by many governments to force companies to reduce sugar levels in foods to combat obesity, possibly with sugar taxes now being trialed in various countries. Then there are laws that require greater checks in supply chains to root out any child or slave labor, dangerous working conditions or other socially unacceptable practices. And some exclusions are legally enforceable, such as banning investments in controversial weapons such as cluster bombs.

Figure 7: Trends in sustainable investing

Source: Robeco

The EU’s Sustainable Finance Disclosure Regulation (SFDR) has provided the biggest shake-up in how sustainable investing is promoted. The regulation aims to make it easier for end-investors in Europe to see which investment products are actually sustainable using a classification system.

Under this system, a strategy is labelled under either Article 6, 8 or 9:

• Article 6: funds that have no sustainability focus and do not promote it

• Article 8: funds that do not have a sustainable investment objective, but do promote environmental or social characteristics

• Article 9: funds that have a clear sustainable investment objective, such as in impact investing

A potential paradox is that certain funds seek to actively engage with companies that are transition candidates, or invest in companies whose current activities are not entirely sustainable, but are allocating significant capex to the transition. These are classed as Article 8 funds, yet they might be considered more impactful than other funds in the Article 9 bucket, whose companies are already sustainable.

However, so long as significant capital is allocated to transition strategies, and SFDR works as intended, more holdings should eventually become eligible to classify as sustainable investments, and with that, the number of Article 9 funds might grow over time.

In that sense, the consultation of the UK’s Financial Conduct Authority (FCA) outlining the direction of Sustainability Disclosure Requirements (SDR) and investment labels for British funds might offer a clearer distinction. This has five buckets labelling funds as ‘not promoting SI’, ‘responsible’, ‘transitioning’, ‘aligned’ and ‘impact’, as shown in the graphic below.

Figure 8: The UK’s SDR

Source: Financial Conduct Authority, November 2021⁹

Much of this is being driven by public opinion, which has moved away from protesting about pollution to demanding a more sustainable approach by companies and those who buy their stocks and bonds. ‘Millennial money’ has been influential here. The generation born since the mid-1980s is set to inherit up to USD 59 trillion between now and 2060, creating the largest intergenerational wealth transfer in history.¹⁰ Millennials are twice as likely as other investors to want to contribute to a better world and believe that they can make an impact.¹¹

Another global initiative to try to create a better world while also earning a return on investment is the UN’s 17 Sustainable Development Goals. These tackle issues ranging from eradicating hunger to improving education for girls, as seen in the chart below:

Figure 9: The SDGs

Source: www.un.org¹²

SDG investing differs from ESG investing in that it seeks to make an impact through the companies that can contribute to the goals along with making a financial return. With ESG investing, the investor will examine the environmental, social and governance characteristics of a company, in tandem with more traditional metrics such as profitability, before deciding whether to buy the stock or bond.

With impact investing, there must be intentionality: a deliberate, targeted effort to exert a positive impact, which must be measurable in terms of how many schools were built or how many emissions were saved, for example. This is not required in ESG investing, although most sustainable investors will try to avoid making a negative impact even if they can’t guarantee making a positive one.

Investors can target funds that in some way or other contribute to one or more of the SDGs. For example, a fund may seek to buy food producers that are investing in healthier and cheaper products (SDG 2), or health care companies that are developing vaccines for use in emerging markets (meeting SDG 3), among others. Some funds now target all the goals by seeking those companies that score highly on SDG impact metrics. (See the Essentials of SDG Investing for our online module about this).

The final megatrend is protecting human rights – which is actually where sustainable investing first came in with those Quakers refusing to fund the slave trade. Exclusions lists can be used to bar investment in any company that tolerates human rights abuses such as modern slavery or child labor in its operations. Engagement is also a useful tool to warn companies of potential human rights issues in their supply chains, particularly when sourcing from conflict areas.

The issue of human rights has been given a higher profile due to rising inequality within nations. Inequality is itself being driven by a number of trends including globalization, marginalization of segments of society, and more recently, the economic effects of Covid. This has partly fueled a rise in populism among people who feel marginalized and financially penalized by ‘progress’. Some countries have faced outright social unrest, which raises risk premiums that can be seen in higher yields on government bonds.

Another human rights concern is digitalization, and its principal drawback – the issue of cyber security and loss of privacy. A study by Credit Suisse showed that the annual cost of cybercrime has reached about USD 500 billion, extracting roughly 15-20% of the internet’s annual economic value. This has, though, presented a significant investment opportunity in the companies combating it, such as security software firms and fintech solutions for bank cards.¹³

Data privacy has often been addressed through engagement, particularly with health care companies which keep sensitive records; banks which host financial data; and social media companies that give platforms to people who then reveal personal details about others.

The times they are a-changing – so you should now see how this is refocusing investment in different arenas, as a new generation takes the reins in deciding where money is spent.

Footnotes

⁸ Carbon Brief, 'The impacts of climate change at 1.5C, 2C and beyond', 2018
⁹ FSC: Sustainability Disclosure Requirements (SDR) and investment labels
¹⁰ Boston College, Center on Wealth and Philanthropy
¹¹ Morgan Stanley, ‘Sustainable Signals’, 2017
¹² https://www.un.org/
¹³ Credit Suisse, 'A Secure Business?', 2017

While interest in SI is growing every day, some misconceptions about it have lingered since it came into public consciousness decades ago.

Perhaps the biggest myth is the idea that using ESG factors in investment processes hurts performance. In fact, there is now plenty of evidence showing that using SI can enhance returns. As this misconception is the most important one to debunk, it is discussed more fully in .

Another pervasive myth is that sustainability is only about green issues. While the environment remains important, ESG means focusing on social and governance factors as well. Indeed, the S and the G can be much more important for some companies than the E.

Meanwhile, a very 21st century misconception is that only millennials are interested in sustainability. While it is true that younger people are more likely to take it into account than their parents or grandparents do, as seen in , research shows that all age groups support the concept of it.

Debunking these kinds of issues requires hard facts, which has generated a myth in itself: that there is not enough data out there to prove that it works. In fact, the real problem here has been that there is too much data, creating an analysis industry of its own to enable investors to make sense of it all.

These are some of the most common myths but there are more, ranging from ’SI only works with equities’ to ‘SI does not work in emerging markets’. Check out our video below for ‘The truth about sustainability investing: facts & fiction’.

Being able to separate fact from fiction is increasingly important in a world of ‘fake news’, so you will now be able to tell clients what SI is really about!

The notion that using SI costs performance comes from the belief that it implies giving up returns in pursuit of some sort of ethical ideal. This is partly true in some sectors; defense companies, for example, are highly profitable due to so many wars raging in the world, yet they are excluded on ethical grounds by most sustainable funds.

There is also a cost in pursuing due diligence on issues such as checking that supply chains do not use child labor, monitoring palm oil plantations to find deforestation, or establishing whether companies are aligning with the Paris Agreement. Using active ownership to engage with companies to improve their ESG credentials while voting against those with poor records is also costly.

But as we saw in the previous chapter, the notion that sustainable investing generally costs performance is a long-standing myth. In the end, sustainable investing is still investing, in which a financial return must be achieved for the asset owners. And it is not something that companies and investors can now ignore.

The world is inexorably changing, fueled by regulation, consumer habits and demographics, including the drive for net-zero emissions to tackle climate change. This is forcing companies to become more sustainable, such as by decarbonizing their activities, amid growing governmental and societal pressure. Those who get left behind will face business models becoming redundant.

For investors, those that are making the time and effort to analyze just how sustainable future enterprises can become will be able to make better-informed decisions about which stocks and bonds to target. This lowers risk exposures while also enjoying enhanced returns, improving the risk/return ratio from both sides of the equation.

The main reason for this is that at the core of ESG integration is only analyzing issues that are financially material – they have a direct financial outcome on the bottom line. This means treating pollution, for example, as a potential future clean-up or regulatory cost for the polluter, rather than as a societal issue of air quality. Companies with poor social or governance factors will eventually underperform those with the right talent and management. It is financial, not emotional.

Evidence of how this works in practice can be seen in a 2020 study by Morningstar, which rates investment funds on a variety of metrics, including long-term performance. It then awards up to five stars for the best funds, an accolade that is highly prized by asset managers.¹⁴

The firm collected the returns of almost 4,900 funds domiciled in Europe, including 745 sustainable open-end and exchange-traded funds, across seven categories. Their performance was measured against non-sustainable funds over a 10-year time horizon.

Table 3: The success rates of sustainable funds found in the Morningstar study

Source: Morningstar Direct. Morningstar Research. Data as of 31/12/2019.

The main finding was that nearly 59% of the sustainable funds that were still being sold in 2019 outperformed their average surviving traditional counterpart. Sustainable funds were also proven to have greater staying power, as 72% of those available in 2009 were still in existence 10 years later, compared to just 46% of traditional funds.

When studying performance right up until June 2020, the research found that sustainable funds held up better than their traditional counterparts during the sell-off at the beginning of the Covid crisis, delivering superior returns in all but one category. Another finding was that lower-cost funds tended to have greater odds of success than funds with higher fees.

“Average returns and success rates for sustainable funds across seven Morningstar categories suggest that there is no performance trade-off associated with sustainable funds,” the firm says. “In fact, a majority of sustainable funds have outperformed their traditional peers over multiple time horizons.”

Summarizing, you should now know that the use of ESG integration leads to better-informed investment decisions that can enhance risk-adjusted returns and be positive for performance. And additional to this the Morningstar study showed that sustainable strategies largely do better, and are more resilient, than their non-sustainable peers. Whereas exclusions are based on ethical considerations, ESG integration is financial, not emotional.

Footnote

¹⁴ https://www.morningstar.com/research

An investor is usually seen as someone who owns a company’s securities with the intention of making a return and/or receiving dividends. But there is another purpose to it. While bondholders provide necessary capital, a shareholder also partly owns that company, and they should therefore use their position to demand change when it is warranted.

Investors are increasingly using their power as owners to influence how the firm is run in order to protect or enhance investments. This kind of active ownership is now at the forefront of sustainable investing, and can be particularly effective when shareholders join forces to effect change on the bigger issues.

There are two main ways of doing this: through voting and engagement. Collaborations where investors work together on either are proving to be increasingly effective.

Investors who are unhappy with a company’s policies can vote against them at shareholder meetings. They can also file proposals to demand change, or block resolutions that they do not like. While individual shareholders with only a small percentage of the stock may not be able to make a difference unilaterally, many investors now bank together to object to things collectively. This has been seen in the growth of investor associations taking a common stand on bigger issues and working collaboratively.

A good example of where a joint resolution achieved positive change was seen in June 2021 when three shareholder-proposed directors were elected to the board of ExxonMobil – against the oil giant’s wishes – because investors saw them as being better suited to fight climate change and guide the company through a transition to cleaner energy.

‘Say on Climate’ resolutions have become increasingly popular. Here, shareholders vote on an energy transition strategy presented by management, confirming whether they think it is a sensible trajectory to decarbonize, or if the company needs to go back to the drawing board.

Something that has become a big issue for voting against is levels of executive pay, particularly when the rises in remuneration for board members do not align with the profitability or success of the company. Under the ‘Say on Pay’ scheme, shareholders can vote against remuneration packages, and even against the reappointment of the director, if they feel that salary packages are excessive.

Voting can be done directly, but is usually done by ‘proxy’ – employing a specialist firm to vote on your behalf. In deciding what standards to follow, many investors follow the principles of the International Corporate Governance Network for assessing best practice. They also in many cases follow local market standards and Stewardship Codes, such as those now operating in Japan.¹⁵

Engagement is the process of entering into a formal dialog with companies that have a problem with some aspect of sustainability that is deemed likely to affect their future performance and asset values.

Such issues cross the environmental, social and governance spectrum, and in serious cases can include all three factors, such as using shareholder power to stop cocoa producers over-farming land (E) while using child labor (S) and being subject to inappropriate management control (G). Increasingly, engagement involves combating slowness in keeping up with international trends such as reducing global warming or improving cybersecurity.

We made a documentary about how engagement actually works. Click on the video to watch it.

However, it is important to distinguish between engaging on a corporate behavior or product. Behavior can often be changed, but if a company makes, for example, cigarettes, then no amount of engagement will persuade them to stop doing so. Here, the investor will move straight to an exclusion.

Where it is possible though, many investors prefer to firstly engage with companies over a contentious issue rather than threaten exclusion. That is because once a company is excluded, it is not possible to engage with it, and investors cannot use their influence to seek ESG enhancements.

Divestment presents a similar problem in that it simply transfers ownership from an unhappy investor to a more willing one, and does not address the underlying issue. Divesting thermal coal producers, for example, may make a portfolio more sustainable, but it has no effect on achieving decarbonization overall. Instead, investor efforts have focused on trying to persuade fossil fuel producers to change business models and switch to renewables.

Collaborations are increasingly important to achieve goals where many investors have a common purpose. While asset managers may disagree about exclusions, impact investing or even the concept of sustainable investing itself, few argue with the need to combat climate change or tackle truly egregious issues such as modern slavery.

This is where collaborations can make a huge difference, particularly when focused on collective engagement. A high-carbon company reluctant to change may find it easy to ignore one investor who wants to see decarbonization; they will find it almost impossible to ignore a collaboration that collectively has a large stake in them.

• A good example is the Climate Action 100+ collaboration. Formed in 2017, the group now has 700 members handling USD 68 trillion of assets under management.¹⁶ Originally set up to target the world’s 100 highest emitters, it now engages with 166 companies responsible for 80% of global emissions.

• Another important collaboration is the Net Zero Asset Managers Initiative. Formed in 2020, this now has 236 members with USD 58 trillion in assets under management committed to the Net Zero Carbon Pledge.¹⁷ This binds members to achieving net-zero emissions in their assets by 2050, in line with national pledges to meet the Paris Agreement.

• Non-climate collaborations include the Platform Living Wage Financials, a Dutch-based group that aims to raise wages in the low-paid textiles, food, agriculture and retail sectors and the International Corporate Governance Network which works to improve the G in ESG worldwide.

Partnerships with academia are also important, particularly in advancing research into SI topics. Cambridge University’s Institute for Sustainability Leadership Investment Leaders Group is a global network of pension funds, insurers and asset managers committed to advancing SI. The Erasmus University Sustainable Value Creation Platform aims to develop new insights through research and education bringing together faculty research, NGOs and professionals in the financial industry.

NGOs can be useful in supplying expertise to their relevant fields, such as the World Wide Fund for Nature Netherlands, which is advising asset managers on how to invest in a more nature-friendly way.

Acting on this information yourself, you should now be aware of how investors can use their ownership to get ESG enhancements at investee companies.

Footnotes

¹⁵ http://icgn.flpbks.com/icgn-global-governance-principles-2017/
¹⁶ https://www.climateaction100.org/
¹⁷ https://www.netzeroassetmanagers.org/

Utilities lie at the forefront of reducing the world’s reliance on fossil fuels. As suppliers of electricity, they have for decades burned coal, gas and oil to meet the growing needs of society. But they can also become part of the solution – as Enel has shown.

The Italy-based multinational power producer has engaged with investors since 2015, more recently under the Climate 100+ initiative which seeks to decarbonize the world’s largest emitters. The engagement sought to encourage the utility – the largest in Europe – to accelerate its move away from the fossil fuel model. This has helped produce some spectacular change.

At first, the engagement focused on phasing out coal, which in 2015 accounted for 20% of Enel’s installed capacity. This has since been more than halved to less than 8% at the end of 2021, with a commitment to a full coal phase out by 2025 in Italy and by 2027 worldwide. The figures refer to eligible activities according to the EU’s Technical Expert Group (TEG) recommendations.

Figure 10: Enel in a nutshell

Source: Enel, Robeco, July 2022

Another milestone was reached in 2020 when the company agreed to the appointment of a renewable energy expert as an independent director on its board. This utilized a feature of the Italian system which allows shareholders to nominate non-executive directors through collaboration with Assogestioni, the association of Italian asset managers.

A third accomplishment came from noticing that Enel was very good at reducing emissions for Scope 1 (generated by the company) and Scope 2 (generated by the energy used), but less so for Scope 3. These are generated by end-users of the product – in Enel’s case, the sale of gas to customers for heating – and are much harder to mitigate.

Engagement on this issue set in motion a chain of events that would lead to a historic pledge in November 2021, when Enel said it would bring forward its net-zero target to 2040 from 2050 across all scopes. If successful, Enel would become the first utility to generate power from purely renewable sources.

Deforestation presents a major threat to climate change. Not only does it destroy a major carbon sink, it also releases the carbon held by trees into the atmosphere, a situation made worse if the trees are burned rather than cut down. One area in which deforestation has been rife is the Amazon rainforest, one-quarter of which has already been destroyed.

To try to combat this loss, the Investor Policy Dialogue on Deforestation (IPDD) met the Vice President of Brazil in January 2020 and held a follow-up call in July of that year. The IPDD is a collaborative group of 55 financial institutions, backed by the Tropical Forest Alliance, World Economic Forum and the PRI. The talks were described as ‘encouraging’ as the Brazilian government pledged to do more to tackle deforestation.

It was the first time that investors had engaged directly with a government. Aside from the need to stop deforestation and protect biodiversity, there is a financial interest in that Robeco has long invested in Brazilian sovereign bonds and equities. The deforestation harms Brazil’s ESG score, which feeds through into lower values for stocks and bonds.

Prior to the engagement, a collaboration of more than 200 investors issued a statement in September 2019 urging companies sourcing products from the Amazon to make sure their supply chains are not involved in rainforest clearance. Much of the beef or soy produced on deforested land is used in Western food production or ends up in restaurants and supermarkets.

The effect that integrating ESG has on investment decision-making can be seen in more than 375 investment cases written by Robeco’s Sustainable Global Developed Equities team from 2017-2022. In over half of the cases, the way in which material ESG factors were integrated impacted the company’s valuation assessment. Most of these adjustments were positive, meaning price targets increased on the back of the in-depth ESG analysis, indicating that the team mainly focused on the opportunities that ESG might bring.

Subsequently, the importance of ESG as part of a company’s overall valuation has been used as an input to proxy the contribution that ESG makes to investment performance. As the table below shows, of all the cases analyzed, 34% had a positive ESG contribution, while 22% had a negative impact on the valuation. In around 44% of the cases, the ESG analysis did not warrant an adjustment to valuation.

Figure 11: How ESG integration leads to value adjustments

Source: Robeco Sustainable Global Stars Equities, January 2021.

In separate research, excluding the tobacco and aerospace & defense sectors from portfolios was found to have a positive impact on returns on average from 2017-2022. However, while they have generally grown less popular over the years, both industries made a comeback in 2022, driven by economic uncertainty and war concerns. This means not having exposure to these industries detracted from performance in 2022.

Plastic pollution is one of the biggest problems facing the environment. Virtually all supermarket products contain plastic packaging in some form, and much of it is single use that does not get recycled. More than nine million tons of plastic is discarded into the ocean every year, which if left unchecked means by 2050 there will be more plastic in the ocean than fish.

The companies producing the plastic have though been open to engagement on how the problem can be tackled. They were asked to make improvements in five areas: innovation management to find solutions and alternatives for single-use plastics; plastic recycling; plastic harmonization to improve the recyclability of plastic packaging; responsible lobbying and more industry collaboration.

Figure 12: Five areas for improvement

Source: Robeco

Nestlé was one standout success. The company outlined a clear roadmap to eliminate harmful plastics and deforestation activities and work to eliminate products made up of a mix of plastics and papers such as in laminates, caps, PVC in liners, and coffee capsule-sealing layers among many others. This initiative illustrates a concrete commitment to reduce the complexity of plastics.

The firm invested EUR 1.5 billion to source two million tons of food-grade recycled plastics over five years so that it can achieve its goal of sourcing 100% of plastics from reusable or recyclable sources by 2025. In 2021, Nestle said 88% of its packaging was recyclable or reusable, more than double the 40% of materials used in 2020 that were from renewable sources.

Finally, ESG analysis can prove extremely useful in spotting risks that pertain to one company but not others, giving an advantage for sustainable stock selection. Such analysis in 2020 was able to spot the potential downside for the corporate bonds of a pharmaceutical company that had slashed its research and development (R&D) budget.

Drug makers usually commit 15-20% of their revenue to R&D to ensure a steady pipeline of new products. However, careful research showed that this company had reduced R&D spending to 3-4%, chasing short-term profits at the expense of long-term value creation. ESG research also revealed excessive executive pay, poor internal controls and huge hikes in the prices of the company’s medicines.

All this created a significant downside risk for owners of its credits. The yield on the company’s bonds subsequently rose steeply against its peer group. This also proved the point that unsustainable companies become more expensive to fund.

In all, as well being able to provide examples to back up your argument is vital, you should now be able to show clients real case studies to reinforce what you have previously learnt.

1. Responsible investing is defined by the UNPRI as “a strategy and practice to incorporate environmental, social and governance (ESG) factors in investment decisions and active ownership.” Sustainable investing takes this further by adopting progressive ESG practices to seek to enhance value, while impact investing aims to make a difference on the ground.
   
   

2. It is not a ‘catch-all’ concept, with no right or wrong way of going about it. There are essentially three approaches: using exclusions; integrating SI more broadly in an investment strategy; or following impact investing. Double materiality is key: looking at the effect a company has on the world, as well as the effect the world has on the company.
   
   

3. ESG integration works through the systematic inclusion of environmental, social and governance issues in investment analysis and is traditionally done in three steps. What is vital though is to focus on issues that are financially material – that have a direct impact on the bottom line. And getting the right data – particularly regarding emissions – is crucial.
   
   

4. SI is connected to some of the biggest issues of our times. Four megatrends are driving it: combating climate change; new regulations such as the SFDR; the Sustainable Development Goals; and human rights. The latter is itself driven by megatrends including inequality that has widened during Covid, immigration and de-globalization.
   
   

5. While SI has become mainstream, there remain a number of misconceptions about it. The most common one is that it leads to lower returns, or is just about green issues when in fact it encompasses the wide spectrum of ESG. Other myths include the idea that it only works in developed market equities, or that only millennials are interested in it.
   
   

6. Research by Morningstar showed that sustainable strategies largely outperformed their counterparts that did not integrate ESG, and also had greater longevity. This is principally because companies that adopt progressive ESG practices seem to have better long-term business models that lead to lower risk or better investment opportunities.
   
   

7. It’s not just about choosing which stocks or bonds to buy; active ownership plays an important role in SI. This is where shareholders use their power as asset owners to influence company behavior, through voting on resolutions, or by engagement. Collaborations between investors have become much more important in effecting change.
   
   

8. Finally, case studies can show how something proven in theory does work in practice. The Enel case shows how engagement can be so effective in changing business models, while collaborations can help stop deforestation. ESG analysis had an effect on valuations half the time for a Robeco strategy, while exclusions both added and detracted from returns.
   
   

Now that you are clear on all these points, you are ready to take the test.